RATIO ANALYSIS

A.AYESHA SIDDIQUA,
M.Com., M.Phil., SET, Ph.D.,
RATIO ANALYSIS
 Ratio analysis is the process of determining
and interpreting numerical relationship
based on financial statements.
 It is the technique of interpretation of
financial statements with the help of
accounting ratios derived from the balance
sheet and profit and loss account.
CLASSIFICATION OF RATIOS
 Analysis of Short Term Financial Position or
Test of Liquidity.
 Analysis of Long Term Financial Position or
Test of Solvency.
 Activity Ratios.
 Profitability Ratios.
TEST OF LIQUIDITY
 The liquidity ratios are used to test the short
term solvency or liquidity position of the
business.
 It enables to know whether short term liabilities
can be paid out of short term assets.
 It is a valuable aid to management in checking
the efficiency with which working capital is
being employed.
 It is also of importance to shareholders and long
term creditors in determining to some extent
the prospects of dividend and interest payment.
IMPORTANT RATIOS IN TEST OF
LIQUIDITY
 Current ratio.
 Quick ratio.
 Absolute liquid ratio.
CURRENT RATIO
It is the most widely used of all analytical devices
based on the balance sheet. It establishes
relationship between total current assets and
current liabilities.
Current assets
Current ratio=
Current liabilities
Ideal ratio: 2:1
High ratio indicates under trading and over
capitalization.
Low ratio indicates over trading and under
capitalization.
QUICK RATIO OR ACID TEST
RATIO
It establishes relationship between liquid assets
and liquid liabilities. It is a refinement to current
ratio and second testing device for working capital.
Quick assets
Quick ratio=
Current liabilities
Ideal ratio: 1:1
Usually, a high acid test ratio is an indication that
the firm is liquid and has ability to meet its current
or liquid liabilities in time and on the other hand a
low quick ratio represents that the firm’s liquidity
position is not good.
ABSOLUTE LIQUIDITY RATIO
This ratio establishes a relationship between
absolute liquid assets to quick liabilities.
Absolute liquid assets
Absolute liquid ratio=
Quick liabilities
Ideal ratio: 1:2
It means that if the ratio is 1:2 or more than
this the concern can be taken as liquid. If the
ratio is less than the standard of 1:2, it means
the concern is not liquid.
II. TEST OF SOLVENCY

 Long term solvency ratios denote the ability

of the organization to repay the loan and
interest.
 When an organization's assets are more than
its liabilities is known as solvent
organization.
 Solvency indicates that position of an
enterprise where it is capable of meeting
long term obligations.
IMPORTANT RATIOS IN TEST OF
SOLVENCY
 Debt-equity ratio.
 Proprietary ratio.
 Solvency ratio.
 Fixed assets to net worth ratio.
 Fixed assets ratio
 Debt servicing ratio.
 Dividend coverage ratio.
DEBT EQUITY RATIO
It Is calculated to measure the relative claims of
outsiders and the owners against the firm’s assets.
This ratio indicates the relationship between the
outsiders funds and the shareholders’ funds.
Outsiders funds
Debt equity ratio=
Shareholders funds
Ideal ratio: 2:1; It means for every 2 shares there
is 1 debt. If the debt is less than 2 times the
equity, it means the creditors are relatively less
and the financial structure is sound.
PROPRIETARY RATIO OR NET
WORTH RATIO
It establishes relationship between the
proprietors fund or shareholders funds and
the total assets
Proprietary funds
Proprietary ratio=
Total assets
Ideal ratio: 0.5:1
Higher the ratio better the long term
solvency (financial) position of the company.
SOLVENCY RATIO
It expresses the relationship between total
assets and total liabilities of a business. This
ratio is a small variant of equity ratio and can
be simply calculated as “100-equity ratio”.
Total assets
Solvency ratio=
Total liabilities
No standard ratio is fixed in this regard.
Higher the solvency ratio, the stronger is its
financial position and vice-versa.
FIXED ASSETS TO NET WORTH
It is obtained by dividing the depreciated book
value of fixed assets by the amount of proprietors
funds.
Net fixed assets
Fixed assets to net worth ratio=
Net worth
Ideal ratio: 0.75:1
A higher ratio, say, 100% means that there are no
outside liabilities and all the funds employed are
those of shareholders.
FIXED ASSETS RATIO
It establishes the relationship between fixed
assets and capital employed
Fixed assets
Fixed assets ratio=
Capital employed
Ideal ratio: 0.67:1
This ratio enables to know how fixed assets
are financed i.e. by use of short term funds
or by long term funds. This ratio should not
be more than 1.
DEBT SERVICE RATIO
This ratio is determined by dividing net profit by
fixed interest charges.
Net profit before deduction of interest
and income tax
Debt service ratio=
Fixed interest charges

Ideal ratio: 6 or 7 times; if the ratio is high it means

there is higher margin of safety for the long term
lenders and as such it is not difficult for the
business to obtain further long term funds and vice-
versa.
DIVIDEND COVER RATIO
It is the ratio between disposable profit and
dividend. Disposable profit refers to profit left over
after paying interest on long term borrowing and
income tax.
Net profit after interest and tax
Dividend cover ratio=
Dividend declared
This ratio indicates the ability of the business to
maintain the dividend on shares in future. If this
ratio is higher is indicates that there is sufficient
amount of retained profit.
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